Economic Models, the Bond Market, and Monetary Policy

In a comment on this post, Bryan asked whether I should not be betting on treasury-indexed securities. I'll answer that one below the fold.

What I have been thinking about is this.

1. In general, I do not think that monetary policy matters much. Instead, I think that the bond market matters, and the Fed plays a relatively small role there.

2. In practice, the Fed's approach to forecasting inflation and bond investors' approach to forecasting inflation will be similar. "Great minds think alike," so to speak. Thus, the Fed and the bond market are likely to start worrying about inflation at about the same time. So, in 1980 we say that Paul Volcker made a difference. In fact, it could be that no matter what he did, bond investors had gotten tired of low real yields and were going to sell bonds, causing long term rates to rise. In other words, bond investors made the same mistake as the Fed in the 1970's--they assumed that economic slack would keep inflation low. By 1980, both investors and the Fed decided that they had to change how they thought about the economy. As a result, interest rates soared.

3. Because "great minds think alike," it may be hard to distinguish the marginal effect of monetary policy from a change in the way the "great minds" view the economic outlook.

4. Right now, a lot of "great minds" are back to 1970's thinking, namely that economic slack means we will see low inflation. That model may not turn out to be true.

I am in fact betting on inflation. Before the financial crisis, I would have described my portfolio as consisting of U.S. and international stock index funds, plus TIPS (inflation-indexed Treasuries). I have a very different portfolio now.

1. I have a very large investment in commodities. I bought oil through the exchange-traded fund USO, but I was not happy with that. That fund way underperforms actual oil, and I made only a small profit when I should have nearly doubled my money, based on the price of oil when I bought and sold. As of now, my main commodity investment is PCRIX, a mutual fund offered by PIMCO.

2. My largest stock market investment is in the Vanguard materials index fund. I call this the "anti-green" portfolio, since it seems to include a lot of chemical companies and such. However, in the last month, I have hedged this by buying the "anti-anti-green" portfolio, an exchange-traded fund, SMN, which goes up when materials stocks go down, and vice-versa. I have decided that stocks have come back plenty, and at this point I would rather have a net exposure close to zero in the U.S. market. If I miss out on a further rally, then so be it.

3. I still have some international stock mutual funds, mostly Asian.

4. I have bought some TBT, the exchange-traded fund that is short the 10-year Treasury. If you think of this in combination with the fact that I still hold some TIPS, then I am doing exactly what Bryan would dare me to do. That is, I am "long" the inflation-index bond and "short" the regular bond, which leaves me net long on inflation.

Each of these is an inflation play. Commodities are an inflation play. The "anti-green" portfolio was an inflation play, although now I am hedged out of it. The Asian stocks are a bet against the dollar, which is something of an inflation play. And TIPS plus TBT equals a pure inflation play.

If anything, I may be betting too much on my own economic views. I probably should be a little more deferential to mainstream thinking.

Comments and Sharing

SMN and TBT reset daily, so their returns vary greatly from the underlying. Timing is important; you don't want to be holding during a major move against your position because it could cause permanent impairment.

I don't quite understand points one and two. If the bond market becomes worried about inflation, and as a result nominal interest rates rise, then for a given monetary policy the higher interest rates would raise the rate of inflation (by boosting velocity.) But inflation fell sharply in the 1980s. What am I missing?

Scott,
You are really an MV = PY kind of guy, aren't you? I was thinking more ISLM-ish, where if the interest rate goes up, investment goes down (or housing and consumer durables go down), Y goes down, and so measured V goes down, not up.

In a world where the only thing an increase in interest rates does is raise velocity, then things are highly unstable. If inflation goes up, then bondholders want higher interest rates, which in your world raises velocity, causing more inflation, causing still higher rates, ....

That can't be right, can it?

Or, to put it another way, how can the real rate of interest go up in your model? Assuming it could go up, would not an increase in real interest rates be contractionary?

ARNOLD: Suppose the Fed decided to set prices (interest rates) and let quantity float, as opposed to what it does not, which is manipulate quantity to get the prices they want (certainly at the short end)?

Or suppose the Fed decided to suspect all Treasury auctions altogether?

Do you realize that all this means is that interest rates would fall to zero as there is no longer any way to drain excess reserves?

Given that we're already at ZIRP, what is the problem with this? If the Fed wanted, they could set interest rates up and down the entire yield curve. The Fed auctions T-bills for interest rate maintenance, not to "fund" anything. The US is not on a gold standard -- it does not need to borrow money from anyone to spend it!

You are quite right though that monetary policy has no impact at all. Since banks are not reserve constrained in their lending, there is no transmission mechanism. The only reason Sumner et al can continue in their position is because they remain ignorant of actual monetary and banking operations.

ISLM is also a lousy model though. If interest rates go up, can't you see an increase in the demand for savings (lower V)? How can you guys even think of V without thinking of savings?

Right now, low interest rates are probably contractionary as they rob the non-govt sector of interest income.

2. Why did you hedge your Vanguard materials with SMN rather than just closing out the Vanguard position. The two can not be perfectly correlated so you are not perfectly hedged.

3. You suggest your materials position is a market position and you are concerned the market is vulnerable to a correction (I share your view). Since the Vanguard materials fund is composed of materials stocks then you could put together a position that is long a carefully constructed portfolio of commodity ETFs that would mimic the Vanguard materials and short the Vanguard materials fund. That would give you a low risk play on commodity markets out pacing stocks in the same commodity markets.

4. You seem to think inflation is all of a sudden going happen like a lightning bolt from the sky. There is going to be a transition that will enable you to get out of inflation vulnerable positions and get into your pure inflation plays (which I think are very clever).

I use the 5 and 10 year TIPS yields to construct the market's 5 year forward 5 year inflation expectation. This is the TIPS markets forecast of inflation after the economy's adjustment to the recession. That is my early warning system. It is currently about 2 1/4 percent which seems very realistic. When that starts moving up I will get out of inflation sensitive investments and consider your inflation plays. Until then I fear your strategy will create dead money.

Arnold, did you understand that when you go long the equivalent of the front month oil contract, you have to pay the roll cost each month when the futures curve slopes upwards? (And that you get paid each month when oil is in backwardation)

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